ESOP's Fable Part 1

Is an Employee Stock Ownership Plan (ESOP) right for your electrical contracting company? What is an ESOP and how do you establish one? In this three part series, we’ll define what an ESOP is, the principal reasons for starting such a plan and the possible pitfalls of employee ownership. First, let’s review how the ESOP concept began.

In the 1950s, lawyer and investment banker Louis Kelso developed the concept of the ESOP, based on his conviction that capitalism would be stronger under an “ownership culture” where employees had a vested interest in their companies. It took 20 years for the U.S. Senate to include provisions allowing for its implementation under employee benefit law, particularly the 1974 Employee Retirement Income Security Act of 1974 (ERISA).

The ESOP Association counts 11,000 ESOPs covering 10 percent of the private sector work force at the turn of the century. More than 90 percent of ESOPs are in privately held companies, and one-fifth are fully owned by their plans.

Why are ESOPs so popular? In 2005, the 14th Annual Economic Performance Survey by the Employee Ownership Foundation reported that nearly 88 percent of responding companies believed establishing an ESOP was “a good decision that has helped the company.”

Two-thirds claimed that their total company performance measures for 2003 improved over the previous year. The largest study of ESOPs to date (Blasi and Kruse, School of Labor and Management, Rutgers University) found similar results, including increased longevity in more than three-quarters of the 1,100 ESOP companies studied. After examining other studies comparing productivity levels, Kruse concluded that ESOP firms showed a 5.3 percent average productivity advantage over those without such plans.

The ESOP should not be confused with employee stock options. The ESOP is a qualified retirement plan that invests in employer stock and gives employees an ownership stake in the company. The ESOP operates as a tax-advantaged tool for raising capital as well as an employee benefit program.

Tax advantages include creating a ready market for company stock, a tax deduction for company contributions to the plan, and an exit channel for owners who can defer or avoid capital gains tax when they sell their equity shares.

The company can acquire capital, borrowing through the ESOP and repaying the loans with pretax dollars. Most plans are leveraged through banks, savings and loans, investment banking firms, insurance companies, or mutual funds.

Other reasons to establish an ESOP include replacing an existing employee benefit program and improving employee morale. An ESOP is fully vested when an employee reaches seven years of service, is open to all full-time employees who have been with the company at least one year and provides them with a “put option,” so they can sell back their shares upon retirement or termination.

Also, employees with more than 10 years in the plan, who are 55 years of age or older, can “diversify” up to half of their shares over the following six years by converting them to other investments.

So, an ESOP appears to be the best of all worlds. The company owners acquire capital, implement a strategy to convert their equity to personal wealth, and employees gain a “piece of the action” and some control over their own destiny. The company makes more money, improves its cash flow, and keeps productive employees happy and loyal. Or is the picture a little less rosy?

Some construction attorneys estimate that they dismantle an existing ESOP for every new plan document they write. Some employees are disillusioned by their actual degree of control; according to the National Center for Employee Ownership (NCEO), only 20 to 30 percent of private ESOPs grant full voting rights to employee shareholders.

Employees who leave their companies sometimes view the flexibility of repurchase timing as a way for employers to reduce the redemption price and devalue their investment. And, post-Enron, how many employees are eager to rely upon the stock of a construction company as the foundation for their standard of living after retirement?

Company owners who celebrate productivity gains for the first year or two after establishing ESOPs may be disappointed with subsequent plateauing of efforts and leveling of profits. Unprofitable years may reverse the positive cash flow effects and make it difficult to continue funding contributions.

At worst, trustees and owners may find themselves defending lawsuits by shareholders, disgruntled family members who believe their equity has been diluted, or government agencies seeking redress for unpaid taxes or alleged ERISA violations.

Clearly, the issues are different for each electrical contractor. Next month, we’ll take a closer look at the advantages of ESOPs, and in the final installment, the costs and risks. EC

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at bigpeng@sbcglobal.net.